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IN THE INVESTMENT world, May 1st is a notable day. It was on May 1, 1975 that the Securities and Exchange Commission deregulated the brokerage industry. For the 183 years prior to that, trading commissions on the New York Stock Exchange had been fixed at uniformly high rates. But when deregulation arrived, competition got going. That’s when discount brokers like Charles Schwab got rolling, and over time, May Day, as it’s now referred to, has delivered enormous savings to consumers.
More than 50 years later, though, Wall Street still operates in ways that are often at odds with consumer interests. As an individual investor, what are the obstacles to be aware of?
At the top of the list is Wall Street’s fixation with individual stocks. For almost 100 years, the data has been clear that stock-picking is counterproductive. Probably the first to uncover this was a fellow named Alfred Cowles. Cowles came from a wealthy family and wondered whether the investment advice his family had been receiving was worthwhile. He set about answering that question and in 1933, published a paper titled “Can Stock Market Forecasters Forecast?” Cowles’s conclusion: They can’t.
More recently, research by finance professors Brad Barber and Terrance Odean came to a similar conclusion. The title of their most well known paper is self-explanatory: “Trading Is Hazardous to Your Wealth.”
Along the same lines, Standard & Poor’s regularly examines actively-managed mutual funds to see how many are able to outperform the overall market. The most recent finding: Over the past 10 years, fewer than 15% of funds benchmarked to the S&P 500 managed to beat the index.
Research by Jeff Ptak at Morningstar has found that the more active a fund is, the worse it performs. So-called tactical funds, which shift among different asset classes in response to economic forecasts have, in Ptak’s words, “incinerated” shareholder dollars.
This data is fairly well known. The problem, though, is that trading activity generates revenue for the brokerage industry, so it has an interest in keeping investors engaged with the market. That’s why brokerage analysts are on TV every day, offering their forecasts for individual stocks, for the overall market and for the broader economy. To be sure, this makes for interesting television. The problem, though, is that it’s been shown to carry almost no value. According to research by Joachim Klement, the accuracy of Wall Street prognosticators is approximately zero.
Why are they so poor at forecasting? For starters, there’s the simple fact that no one has a crystal ball. No one can know what a company—or its competitors—will do a month or a year from now, and how that will translate into stock price gains or losses.
Sociologist Ezra Zuckerman Sivan uncovered a more subtle explanation. In research published after the technology selloff in 2000, Sivan found that Wall Street analysts are constrained by two obstacles. The first is that they’re dependent on access to companies’ management teams to help in their research. For that reason, it’s in their interest to maintain positive relationships with the companies that they follow.
Investment banks that take a positive view on a company may also be rewarded with profitable mergers or acquisitions work when the need arises. Those factors bias stock recommendations overwhelmingly in the direction of “buy” ratings.
Another reason analysts tend to avoid negative comments about the companies they cover: Sivan found that there is a community effect that tends to form among the analysts assigned to a given company, and thus an incentive develops to not “rock the boat” in saying anything too critical. People generally want to get along, and that results in a sort of self-censorship.
This research is well understood, and yet Wall Street continues to generate forecasts day after day, year after year. Why? There are two explanations, I believe. The first is that it’s entertaining. I’ll be the first to acknowledge that index funds aren’t terribly interesting to talk about. It’s far more interesting to talk about smartphones or AI and the companies behind them. That makes Wall Street analysts invaluable to the media, who need to fill airtime.
And as long as they’re granted that airtime, forecasters are of great value to the brokerage industry. Since trading activity is profitable for Wall Street, it’s in brokers’ interest to generate continued interest in stocks. That brings in commission dollars for brokers. And even though commissions have shrunk in recent years, brokers benefit in other ways from active trading, including the “bid-ask spread” on each trade. That’s the difference between what buyers pay and what sellers receive, and though these spreads are tiny, they add up for the brokers who collect them.
For good reason, then, Wall Street continues to promote stock-picking. At the same time, the investment industry is always busy developing new funds. In the first half of last year, for example, fund companies rolled out more than 640 new funds. Among them: funds that hold single stocks with varying degrees of leverage and other seemingly unnecessary new formulations. The result: There are now many more funds than there are stocks trading on U.S. exchanges.
Many of these new funds follow ever more esoteric strategies. They’re often opaque. And almost invariably, they carry higher fees. In a 2011 study titled “The Dark Side of Financial Innovation,” finance professor Brian Henderson and a colleague looked at one popular category of fund known as a structured product. Their conclusion: These funds were overpriced to the point that their expected return was actually a bit below zero. How were they able to market such an inferior product? Henderson’s hypothesis was that the fund companies designed them to be intentionally as complex as possible in order to exploit individual investors.
The bottom line: To a great degree, Wall Street is upside down. But as an individual investor, you don’t have to be. My rule of thumb: In building a portfolio, investors should do more or less the opposite of what Wall Street recommends. That, I believe, is a reliable formula for success.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
Burton G. Malkiel still looks pretty good, 60 years after “A Random Walk Down Wall Street.” Basically he concludes (at the end of a book that’s surprisingly entertaining to read) that you can’t beat the market by stock-picking (except by taking on more risk, which means… taking on more risk!). Long before Bogleheads were a thing, this basic truth was already known — but lost in the noise.
Good article, Adam. I agree wholeheartedly but would add one thing. We still need for a lot of people to buy individual stocks for purposes of finding the right price of the stock. Funds/ETFs rely on having the stocks they are holding priced correctly if there is to be true valkue there.
I seem to get daily emails and phone notifications recommending individual stocks. Personally, I’ve always followed one simple rule: ignore the noise. It’s certainly served me well over the years.
Great article. I follow a lot of the Wall Street strategists’ social media posts and get their emails, etc. Super smart people and I feel like I learn a lot about the market environment as I read. Then they conclude with, “We expect a wide dispersion of returns, putting a premium on stock selection.” And you just know they HAD to say that.